Internal transfer prices when only part of an order fits spare capacity

An internal supplier may have enough unused capacity for the first part of an order but need to give up outside sales to complete the rest. Treating the entire order as spare-capacity work understates its opportunity cost. Treating every unit as displaced outside business overstates it.

ACCA frames a selling division's minimum transfer price around marginal cost plus contribution forgone. Applying that principle requires identifying how much of the proposed internal volume actually displaces an alternative sale, rather than choosing one cost rule for the whole plant.

This guide concerns an internal management decision and divisional incentives. It does not establish a tax transfer price or replace the documentation and pricing rules that may apply to transactions between legal entities. The numerical case isolates the operating economics.

Assume a hypothetical selling division can produce 1,000 units during the decision period. External customers will buy 700 units at $100 each. Variable production cost is $60 per unit, and each external sale requires another $10 of selling cost that an internal transfer would avoid.

The selling division therefore earns $30 contribution from each external unit: $100 less $60 less $10. It has 300 units of spare capacity after satisfying that demand. Fixed costs will not change under any of the alternatives considered.

A buying division needs 700 equivalent units and can buy them outside the group for $85 each, including the relevant delivery and handling costs. Initially assume its internal production order is indivisible: the seller must supply all 700 units or none. Later, remove that restriction to see why it matters.

Producing all 700 internal units costs $42,000 at the $60 variable rate. The first 300 use spare capacity. The remaining 400 displace external sales, giving up 400 multiplied by $30, or $12,000 of contribution.

The selling division needs $54,000 of transfer revenue to cover both effects and remain economically indifferent to the all-or-nothing order. Spread across 700 units, that is approximately $77.1429 per unit. The buying division's outside alternative costs $59,500, or $85 per unit.

There is therefore a feasible whole-order transfer-price range from about $77.14 to $85, before allowing for rounding and any costs excluded from the example. The range exists because the internal order saves the group $5,500 compared with buying all units outside while preserving the seller's 700 external sales.

Suppose the divisions agree to $80 per unit for the full order. The buying division pays $56,000 instead of $59,500, improving its result by $3,500. That is one share of the group's gain, not an additional gain beyond it.

The selling division earns $14,000 contribution on the internal order: $56,000 transfer revenue less $42,000 production cost. It also retains 300 external sales at $30 contribution, or $9,000. Total contribution is $23,000 against the original $21,000, an improvement of $2,000.

The two improvements sum to $5,500. Internal transfer revenue and internal purchase cost cancel in a group view. Choosing $80 rather than another price within the feasible range changes how the gain is divided; it does not create extra group cash.

Now suppose the buying division can source 300 units internally and 400 outside without extra costs or other restrictions. Internal production uses only the spare capacity, so none of the 700 external sales is displaced.

The relevant resource cost is $18,000 for 300 internal units plus $34,000 for 400 outside purchases, totaling $52,000. That is $2,000 better than the all-internal order's $54,000 cost including contribution forgone, and $7,500 better than buying all 700 outside.

The reason is marginal: each internal unit beyond the first 300 costs the group $60 plus $30 of lost outside contribution, or $90. Buying that unit externally costs only $85. A blended whole-order price below $85 must not conceal the unfavorable economics of those additional constrained units.

An indivisible order may arise from a practical batch constraint, a qualification requirement or a single-source specification. Those restrictions need evidence. They should not be introduced merely to make a proposed flat transfer price look acceptable.

Conversely, partial sourcing can create inspection, coordination or setup costs that the simple case excludes. If splitting the order adds more than $2,000 relative to all-internal supply, the apparent advantage of the split disappears under the other stated assumptions.

The capacity timing matters too. Spare hours in one week may not serve an order needed in another. Compare the demand and capacity within the actual decision window. An annual spare-capacity percentage cannot establish that a particular dated order has no opportunity cost.

The lost amount is the contribution from the best available alternative that must be forgone. In the illustration, the $10 external selling cost is avoidable, so using the full $100 price less only the $60 production cost would overstate the loss by $10 per displaced unit.

Check whether outside demand is firm, whether customers can wait and whether displaced orders can be served through another route. If the best alternative changes, its contribution changes. A published price list alone does not prove that the seller could have earned that contribution on every constrained unit.

Keep fixed allocations separate unless the decision actually changes the underlying commitment. Adding the same unavoidable fixed charge to every internal unit can distort the decision without altering any group cost. A divisional performance arrangement may need a separate treatment for those commitments.

First identify the best feasible sourcing mix. Then choose a transfer arrangement that allows the divisions to implement it without making one manager appear worse for following the group's preferred decision.

The useful calculation is a schedule showing spare units, constrained units, contribution forgone and outside purchase alternatives. It explains when a blended order price is meaningful and when it hides a better partial-sourcing choice. That distinction matters more than selecting a familiar percentage markup.